A few weeks ago, I was talking to my friend Jim*, and he was venting about a problem he had with his Social Security check at the beginning of the year. Jim said he didn’t receive a check during the first few months and he couldn’t understand the explanation the Social Security Administration (SSA) gave him, which was to claim that he was “still working.” When I asked Jim how old he was and he answered 64, everything became clear to me. I said, “You exceeded your earnings limit.” He responded with a confused “Huh?”
Social Security is a cornerstone for most people’s retirement. However, many make the mistake of believing that the decision to start collecting when they retire is a simple one. Until you begin to understand how Social Security works, you realize the answers “Don’t Come Easy.” (How can Ringo Starr play piano in mittens? I mean, come on!) Even though some options were curtailed back in 2015, there are many points to consider before choosing when to start collecting your money, such as:
- When do you think you will die? (Unpleasant, but necessary)
- When do you think your spouse will die? (Again, necessary to consider)
- What is the age difference between you and your spouse?
- How long do you plan on working?
- How much will you earn working?
- Do you have dependent children or grandchildren?
There are two terms you must know when discussing Social Security: Full Retirement Age (FRA) and Primary Insurance Amount (PIA). The PIA is your monthly benefit amount (The SSA nearly always discusses amounts in monthly terms.) If you start collecting at your FRA, you will receive 100% of your PIA. (Please note the SSA is increasing the FRA from 66 to 67, depending on the year you were born. This means your FRA could be different than your spouse’s.)
As a benefit, Social Security has a fair amount of flexibility built into it, but there are trade-offs involved. You are allowed to start collecting any time between ages 62 to 70. If you start collecting after your FRA, you will get more than 100% of your PIA. Collecting prior to your FRA will result in you getting less than your PIA.
So where does the earnings limit that confused my buddy Jim come into play? Since Social Security is meant for retirement, the program penalizes you if you collect a check before your FRA and while you’re still working. Generally speaking, for every $2 you earn over the limit (which is determined by a formula and adjusted each year for inflation), $1 is deducted from your Social Security check. There is a special provision for the YEAR you reach FRA, but before the MONTH you reach FRA, that allows for a higher income level before the deduction kicks in. In this instance, the reduction is $1 for every $3 instead of $2 earned. As an example, here are the 2020 limits (from Social Security website):
These limits apply only when you are collecting before your FRA. If you worked the first nine months of a year earning $300,000, and then you turned 66 and filed to start collecting your benefit, you would not have to worry about this limit.
The next thing to be aware of is what the SSA considers “earnings.” Earnings, for this rule, are any monies you earn from a job, including self-employed income. What it does not include are income sources like IRA distributions, investments, rental income, and unemployment benefits. Moreover, only your individual wages are considered; your spouse’s income is ignored. In Jim’s case, if he wasn’t working and his wife earned a $100K salary, he would not have seen any reduction in his payments.
On a positive note, some of the money deducted for the earnings limit is not lost forever. The SSA gives you credit for these deductions after your FRA. The SSA tracks how much is withheld and, once you hit your FRA, it adjusts your beginning date to compensate for the lost income. For example, if you filed as soon as you turned 62 (setting your Social Security income at the lowest possible amount) and, because of the earnings limit, you had 18 months of benefits held back, then the SSA would increase your monthly check at the time of your FRA as if you had filed at age 63 and 6 months instead of at 62. This change happens once you reach FRA.
That is how the earnings limit reduction is calculated. The mechanics of how the withholding is done is important to understand too.
Instead of reducing each check by a certain percentage, the SSA withholds all monthly payments until the penalty amount is accrued. This means that if you should get $1,000 per month, but the earnings reduction is $3,000, then you will not receive your monthly check until April because the SSA will hold back payments from January to March.
How does the SSA know how much to withhold from you? You tell them. At the beginning of the year, you must provide Social Security with the amount you think you will earn and then they do the math. Warning: If you do not tell them you have wages, or give them a number that is less than you actually earn, then the SSA will notify you of the overpayment and expect that money to be returned to the government as a lump sum. They will not adjust your monthly check to reclaim the money. You have to write them a check.
You also need to know that your Social Security benefit is subject to income tax. Unlike the earnings limit though, this is money you will not get back. Moreover, unlike the earnings limit, taxation does not end once you reach FRA. Your benefit is potentially taxable for as long as you are collecting.
Not all of your benefit is taxable: at least 15% is protected from Uncle Sam. How much is exposed to taxation depends on your income. But in this case your entire household income is counted, and not just what you earn from your job. This will include payments from retirement accounts (including Roth Conversions) and your spouse’s income.
Social Security payments are one part of Retirement Income Planning. And just like planning your comprehensive retirement income, when it comes specifically to Social Security, there are several options and trade-offs to consider. Many people are tempted to collect their Social Security as soon as they can, and there are reasonable motives for doing so. However, you need to consider all of the factors when making that decision.
Please reach out to us to better understand how to use Social Security to support your retirement dreams.
*Name has been changed for privacy reasons.
This information is not intended to be a substitute for individualized tax advice. Please consult your tax advisor regarding your specific situation.
Investment advice offered through Private Advisor Group, a registered investment advisor. Private Advisor Group and American Financial Management Group are separate entities.
Kevin focuses on helping people with retirement income planning. He is concerned that too many people become overwhelmed as they shift from building their retirement savings to using their retirement savings to support their desired lifestyle. By engaging in a robust planning process, he aims to lessen the financial fears we all have after we end our careers. Learn more about Kevin